Monday, 8 November 2010

Contra Krugman, Continued

First, of course, the obvious question: why does any of this matter? So what if Government Gus has to pay a slightly higher interest rate on his debts? Won’t the benefits of his spending (higher employment, income and consumption, which combine to help the private sector clean up its balance sheet) outweigh the costs?

I don’t think they will. And the reason, as usual, is positive feedback. If the tipping point is reached, Gus won’t have to pay a ‘slightly higher’ rate on his debts; he will have to pay a rate that is significantly higher. High enough to burst the bond bubble and send foreign investors running for cover; high enough to send the dollar plummeting; high enough to put into serious doubt the government’s ability to roll over its debt. The US could end up in a situation like Greece. Worse, in fact, given the size and importance of the US economy, the US bond market and the US dollar.

The bursting of a bond bubble is far more dangerous than the bursting of an equity bubble or a real estate bubble. Immediate consequences include massive benefit cuts (social security and medicare), large tax increases and high inflation. Delayed consequences include steep declines in the standard of living, social unrest, and possibly war. Any policy that increases, however minutely, the likelihood of such outcomes should be considered very very carefully: is it really worth it? And in the case of QE2, I don’t think it is.

Second, I have just read through several hundred NYT blog posts by Prof. Krugman, and I notice that he has (explicitly or implicitly) addressed several of the arguments I made in my previous post. I would like to counter his points, one by one.

But before I do so, I want to make it clear that there is no personal or political animus behind my current stance. For what it’s worth, I was and am a great admirer of Prof. Krugman, as an economist and as a communicator. And I suspect that my policy baseline is very similar to his (pro free markets but with a strong appreciation of their limitations). In many cases and on many topics I agree with everything he writes.

Having said all that, I think he is dead wrong when it comes to the bond market and how it interacts with optimal government policy. And since that is a subject on which I consider myself an expert, I feel duty-bound to comment, at length. Hence my current series of blog posts.

On to Prof. Krugman’s points, in italics below.

“I base my argument on fundamentals, not market signals”

A bit of background: some critics (not me) have pointed to the fact that Prof. Krugman did not believe in the accuracy of market prices in 2006 (at the peak of the housing bubble), but seems to believe in their validity today (when it comes to interest rates). Prof. Krugman’s response to this criticism is that in all cases he is building from fundamentals, and not relying on market signals.

Fair enough, is what I say. There’s no rule that states you have to agree with the market all the time, or for that matter disagree with the market all the time. Sometimes you may think prices are justified, at other times you may think they’re incorrect. That’s fine.

What’s not fine, however, is to then use market prices as ‘additional support’ for your fundamental thesis. If you’re building from fundamentals, then fundamentals should be all you talk about. It’s not fair to constantly cite (as Prof. Krugman does) the low level of interest rates as support for your position that the market is unconcerned about deficit spending. Especially if at other times you are willing to discount market prices since they don’t conform to your position. This I think is hypocritical.

“QE2 does not materially affect the path of future deficits”

I agree that QE2 as currently envisaged won’t really affect deficits; it’s too small (or, equivalently, the current level of deficits is too big!). For the same reason, I think QE2 will be largely ineffective when it comes to its primary purpose, which is boosting spending1.

But that’s irrelevant. The relevant mechanism here is positive feedback operating on traders with short horizons, who know that they’re in a Keynesian beauty contest. The actual level of deficits matters less than the psychological perception thereof.

This of course leads neatly into Prof. Krugman’s next point:

“Explanations that invoke market psychology are worthless”

With all due respect to Prof. Krugman as a brilliant academic economist, I think I’m much better qualified to judge the value of psychology in markets than he is. And speaking with the experience of over a decade as a (fairly successful) hedge fund trader, I have to say that Prof. Krugman is simply wrong. Psychology, herding, momentum, feedback, call it what you will: it matters, it really does.

Again, note that by invoking ‘psychology’ I am not invoking ‘irrationality’. It is perfectly rational for traders in a Keynesian beauty contest to care about other people’s (no doubt subjective) perceptions of value; indeed, that’s the whole point of Keynes’ argument.

“Critics have their own personal or political agenda”

I addressed this in my preamble; let me add here, for the record, that I am not a US citizen, do not live in the USA, and do not pay US taxes. My personal stake in US fiscal / monetary policy is minimal. However, I do believe that a strong and healthy US economy is in the best interests of the world at large, and I would like to see such an outcome eventuate. Political economy need not be a zero-sum game.

“Critics were wrong about the dotcom bubble and the housing bubble; why should we listen to them now?”

There is a whiff of ad hominem in this point, nonetheless I think it’s justified; after all economics is an inexact science with no impartial arbiters, and there are lots of hacks out there who are either incompetent or malicious or both. I think it’s fair to ask ones’ critics what their credentials are, and if they have a track record of being consistently and risibly wrong, then it’s fair to ignore them.

For what it’s worth, my first ever professional trade, shorting USD swap spreads in 2000, was based on the macroeconomic conviction that the dot-com bubble would burst, pushing tax receipts lower and necessitating increased Treasury issuance. In 2001 I predicted (not online, unfortunately) that low interest rates would lead to a housing boom and potentially a housing bubble. In 2004 I set my first small shorts in homebuilder stocks. I added to these over the next few years; by 2007-08 I was short Toll Brothers, Fannie Mae, Freddie Mac, Citibank and Goldman Sachs. Every one of these trades made money. I have made many mistakes in my time as a trader, but failing to recognize the dot-com and housing bubbles was not one of them.

Of course, I could still be wrong about what happens next; I could be imagining a bond bubble where none exists. Past performance is no guarantee of future returns. But at any rate I think I deserve to be taken seriously, as a credible analyst of markets.

“Inflation is not a worry; core CPI is at just 0.8% yoy”

This point is usually bracketed with some snide remarks about inflationistas always being wrong; this time, I will ignore the ad hominem, and confine myself to four points in reply:

First, this is a statement about the past and the present, not about the future, and thus has limited predictive power, especially with respect to a measure as driven by expectations as is inflation. It’s equally relevant (or irrelevant) to point out that just 2 years ago, all-items CPI was running at 5% yoy.

Second, core CPI (that is, CPI excluding food and energy) is a terribly flawed measure. Food and energy prices may be volatile, and demand for them may be price-inelastic, but if they show a decade-long secular uptrend, then they should be included in any accurate inflation index.

Third, even non-core CPI is suspect, because of all the hedonic and other adjustments that have been made over the years. Almost every adjustment seems to have biased CPI downwards. Is it mere coincidence that the entities that publish these numbers have an incentive to keep them low? I think not.

Fourth and most important, I believe the macro dynamics at play make CPI (whether core or all-items, whether hedonically adjusted or not) an irrelevance. The danger is not CPI inflation, it is asset price inflation. As I wrote on this blog some time ago:

China has exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.

Or to put it another way: China supplies certain items that are mostly included in CPI (labor and goods); China demands certain other items that are mostly excluded from CPI (food, energy, and assets – mainly bonds). Naturally, this distinction affects the quoted level of CPI. Ignoring this distinction means fundamentally misunderstanding the macro dynamics at work today.

“Critics have no coherent macro model of their own”

Actually, I do have a macro model of what’s going on, and I think it’s very similar to Prof. Krugman’s own. I am happy to concede that the US is in a liquidity trap similar to that of 1990s Japan, and I concur fully with the analysis in Prof. Krugman’s classic paper addressing the Japanese experience.

Where I differ from Prof. Krugman is in the policy implications of his analysis. Specifically, I disagree strongly with this paragraph, which many would call the key conclusion of that 1998 paper:

The way to make monetary policy effective [in a liquidity trap] is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

I have no doubts that such a strategy would ‘work’. But the thing is, such promises have a way of getting out of hand. You can’t ask for ‘slightly higher’ inflation – say, from 1% to 4% – and expect matters to stop there. Inflation is all about expectations, and once expectations become unanchored, the sky’s the limit. Arthur Burns and William Miller (successive Fed chairmen in the 1970s) both tried to foster temporary ‘slightly higher’ inflation in order to boost employment. Both failed miserably: unemployment stayed stubbornly high while inflation skyrocketed. It took Paul Volcker and two deep recessions to bring it back under control.

I think this a clear case of the cure being worse than the disease. But then, what’s the alternative? This brings us to Prof. Krugman’s last and best point:

“Critics have no policy solution of their own”

Okay, so I don’t believe that the Fed should promise to irresponsibly deliver inflation. And I don’t believe that the Treasury should spend trillions of borrowed dollars to bail out the consumer. So what do I believe? How do I propose to get the economy out of its current recessionary mire?

Sadly, I don’t think there’s an easy answer. Economic policy is not a magic bullet; it cannot achieve the impossible. And to expect that 300 million Americans can be returned to the same patterns of income, employment and consumption that obtained before the crisis, with no adverse long-term consequences, is to expect the impossible.

Why so? Because those patterns were always unsustainable. For many years, the United States has been consuming more than it produces; importing more than it exports; spending vast sums on unnecessary wars; and spending not enough on education, infrastructure, research and technology. These deep structural imbalances were allowed to persist by a complex global financial web, which was in turn driven by the short-term incentives of participants around the world (from the Wall Street mortgage machine, to Bretton Woods II and the Asian accumulation of Treasury debt). But ‘if something cannot go on forever, it will not’. In 2008 we saw the first unravelings of that global financial web. The process picked up momentum (positive feedback as usual), and before we knew it we were in the Great Recession.

This unraveling is not something that can be easily reversed, or perhaps reversed at all. And perhaps it should not be. After all, we have been here before. When the dot-com bubble burst, the Greenspan Fed eased monetary policy to an unprecedented degree, in order to avoid short-term pain. The result was an even bigger bubble, in housing. And now that the housing bubble has burst, Prof. Krugman wants the Bernanke Fed / Geithner Treasury to break new frontiers in easy policy, again to avoid short-term pain. The result will be a still bigger bubble, in bonds. You can’t play this game forever; sooner or later the piper will have to be paid. And every new bubble inflicts more pain than the last, when it eventually bursts (see the fourth paragraph of this very blog post).

So my policy solution, insofar as I have one, is to embrace the unraveling. The recession won’t last forever. Over time, I expect to see some combination of a lower dollar, higher inflation and lower real wages in the United States. These will lead to a lower standard of living and higher exports. And these two consequences are the key: it is these, and these alone, which can see the United States break out of its rut. A lower standard of living and higher exports are necessary to repair private sector balance sheets, bridge the gap between production and consumption, and plug various deficits. But it will take a long slow grind to get there; we could easily see a decade or two of secular stagnation, a la Japan.

It’s not what I would have wished for. But it’s the least bad option.

Footnote

#1In fact, you could make a strong argument that for QE to be effective at all, it has to materially affect deficits; this is akin to the idea of being ‘credibly irresponsible’ which I shall address below. (No, Virginia, Ricardian equivalence does not hold in the real world).